Choosing the middle way
René Biner offers a 21-year data set that reveals surprising facts about historical loss rates in European mezzanine debt – and the advantages of vintage-year diversification
In an environment characterised by uncertainty, weak GDP growth and record-low interest rates, investors are in search of yield. European mezzanine investments offer investors attractive floating base rates that address their need for yield, while at the same time protecting them from an inflationary interest rate environment.
This article discusses the loss rates of European mezzanine investments as well as the year-over-year volatility of those loss rates. We analysed transaction data from a comprehensive set of 439 mezzanine investments that were fully realised on or prior to 31 December 2012. All 439 investments were made between 1989 and 2009, a 21-year period that covered several economic and market cycles (the ‘observation period’).
The analysis yielded several conclusions:
• Loss rates for European mezzanine investments during the observation period were relatively low overall at an annualised rate of 1.8%.
• However, a meaningful year-over-year volatility did exist.
• By building portfolios that spanned multiple investment years, the volatility of both loss rates and returns may have been meaningfully reduced with minimal impact to returns.
• The returns, in aggregate, were never below 1 time for any vintage year, with a total pooled investment multiple of 1.59 times of invested capital from the 439 European mezzanine transactions.
Mezzanine investments are generally private debt instruments that take the form of loans or notes and are typically subordinated, or junior, to the senior debt. Mezzanine investors usually receive their returns through contractual cash interest payments, capitalised interest payments known as ‘payment-in-kind’ (PIK) interest that is added to the principal on each interest payment date and a return of the principal plus any accrued PIK interest on the maturity date. In a typical European transaction, the cash and PIK interest components are typically quoted together as a total margin over a base interest rate, usually LIBOR or EURIBOR.
As one might do for a fixed-income security, the overall interest rate of mezzanine investments should be compared with the risk of potential losses of principal in order to assess the overall attractiveness of these investments.
In order to assess the risk of principal losses for European mezzanine investments (EMIs) across different economic cycles, a unique data set was constructed comprising 439 fully-realized EMIs made by mezzanine investors during the observation period between 1989 and 2009 and realised prior to 31 December 2012, comprised of both the principal amount of the mezzanine loan together with any equity investments made by such mezzanine investor as a part of the investment. Figure 2 shows the number of EMIs included in the data set by investment year, which displayed an average of approximately 21 deals per year.
During the observation period, the overall loss rate (defined as the loss of capital as a percentage of the overall invested capital, whereby the loss of capital represents the invested capital less realised amounts of investments with investment multiples below 1 time) for all of the EMIs was limited to 5% of total invested capital. The average duration of the EMIs was 2.8 years. This results in an annualised loss rate of 1.8% of invested capital.
Further, of the 439 EMIs made during the observation period, only 7.3% (representing approximately 6.6% of total invested capital) ultimately exited at an investment multiple of less than 1 time (ie, less capital was returned than originally invested).
It is important to note that loss rates do not equal default rates: although most if not all investments with an investment multiple below 1 time have defaulted, defaulted investments that underwent successful work-outs can achieve investment multiples in excess of 1 time (ie, recovery in excess of 100% of invested capital). At the same time, the EMIs achieved impressive realised returns with an investment multiple of 1.59 times invested capital and a median IRR of 18.7%.
When viewed against the backdrop of volatile euro-zone GDP growth during the same observation period, the EMIs exhibited significant relative stability.
During the observation period, while euro-area GDP growth ranged from a peak of 3.9% in 2000 to a low of -4.3% in 2009, the EMIs provided a maximum return to investors of 2.37 times in 1996 and a minimum of 1.29 times in 1992.
Interestingly, this relative stability in the return multiples for the EMIs was achieved despite the decline in average holding periods. The average holding period for the EMIs declined from 3.1 years in 2001 to 1.9 years by 2005 due, in part, to the liquidity in the debt capital markets during this time. The liquidity and resulting decrease in the cost of capital enticed borrowers to refinance existing indebtedness and caused decreased holding periods for the EMIs. However, by late 2007 and 2008 that liquidity had largely eroded and the mezzanine market witnessed a rapid return to longer holding periods that continued into the post-Lehman crisis period.
In light of the relatively low average loss rates and the attractive average returns – paired with the variability of both metrics across the Observation Period – we analysed the performance of portfolios comprised of mezzanine investments made during any two consecutive investment years and any three consecutive investment years.
Although underperforming investments and loss rates are clustered around times of general economic weakness or uncertainty, such as the early 1990s, the late 1990s/early 2000s and the 2007-09 crisis (the 2006 vintage, for example), multiple-investment-year portfolios show a significantly lower volatility of loss rates compared with single-investment-year portfolios.
For example, the highest three-year loss rate of 9.5% resulted during the three-year investment period ended 2007, highlighting that a multi-investment-year portfolio in that vintage clearly mitigated the loss rate of 13.5% set during 2006 (which is also the maximum loss rate of any single year). In addition, the one-year average loss rates range from 0-13.5% in the observation period. However, when the same analysis is undertaken for three-year investment periods, the loss rates range narrows to 0.8-9.5%. In other words, with a small sacrifice to the minimum loss rate, investors could significantly reduce the maximum loss rate. Further, the standard deviation (a measure of volatility) is reduced from 4.1% for one-year investment periods, to 2.6% for the three-year investment period.
Similarly, by investing over three-year periods, the volatility of the returns was significantly reduced. For example, the range of investment multiples across each of the 19 different three-year investment periods was 1.44 times invested capital to 2.01 times invested capital. On the other hand, as mentioned previously, investment multiples for each one-year investment period ranged from 1.29 times invested capital to 2.37 times. Further, the average and median investment multiple for the three-year investment periods was 1.67 times invested capital and 1.66 times, respectively, versus 1.69 times and 1.65 times, respectively, for the one-year investment periods.
It is evident that while the upside is reduced marginally, there is a significant improvement to the downside of the range. As further evidence of the reduction in volatility, the standard deviation for the investment multiples for the three-year investment period is 0.16 times versus the more volatile 0.26 times standard deviation associated with the one-year investment periods.
During the observation period, which encompassed multiple economic cycles, European mezzanine investments have, on average, delivered attractive and stable median returns exceeding 18% IRR and 1.6 times multiple of invested capital to investors with relatively low loss rates, annualis ed at 1.8%. Although all investment years delivered positive returns, the variability of returns and loss rates was meaningful across vintages. However, by constructing portfolios across multiple investment years, investors may be able to reduce this volatility while continuing to deliver consistent investment returns. The mezzanine asset class not only delivers strong risk-adjusted returns to investors across economic cycles, but also protects returns during rising interest rate environments due to its floating base rates. Such favourable characteristics of European mezzanine investments can be expected to foster interest in mezzanine as a separate asset class.
René Biner is head of the private finance business department and co-head of the private debt team at Partners Group